Quarterly profit announcements by Chinese banks this month have set off a national debate over whether the banking sector is excessively profitable. Criticisms of bank profitability have even come from prominent former People’s Bank of China (PBoC) officials. Wu Xiaoling described bank profits as unreasonable (Chinese language) and Li Daokui referred to banks as profit-devouring dinosaurs.

ICBC president Yang Kaisheng fired back arguing that the interest rate spread for China’s banks is low compared to economies with liberalized interest rate regimes. Therefore, according to Yang, it’s unfair to attribute the high profitability of Chinese banks to the fixed interest rate spread.

The fixed interest rate spread is the result of the ceiling on deposit rates set and a floor on lending rates mandated by the PBoC. These rates are set to give banks a comfortable margin of around 3 percent.

As Nick Lardy points out in Sustaining China’s Economic Growth After the Global Financial Crisis, to sterilize the effects of its currency intervention policy, the PBoC forces banks to put lots of money into low-yielding required reserves and central bank bills, an amount equivalent to 40 percent of last year’s GDP. Forcing banks to buy these low-yielding assets invariably lowers their net interest spreads and thus Yang’s comparison with banks in other countries is misleading. For Chinese banks to have similar net interest spreads even after buying all these low-yielding government assets means that their other operations must be very profitable.

The profitability of Chinese banks is primarily the result having plentiful access to household deposits, which make up the largest source of bank funding and enjoy a higher spread than other sources of funding. A repressed financial system with a high savings rate means that banks have access to lots of deposits and not much competition from other financing sources.  The chart below from the World Bank China 2030 Report illustrates nicely the bank-dominated structure of the Chinese financial system.

The artificially low interest rate environment means that the demand for loans almost always exceeds the supply. The PBoC limits loan growth through quantitative measures (such as the loan-to-deposit ratio), but the loan-to-GDP ratio in China is unusually high for countries at its level of development. High loan volume boosts Chinese bank’s aggregate profits because the fixed interest rate spread guarantees bank profitability.

The end result of these distortions is that Chinese banks are quite profitable, too profitable in fact. Net profits for commercial banks grew 36 percent last year, reaching 1 trillion renminbi. Chinese commercial bank return on assets in the fourth quarter was 1.3 percent (compared to 0.76 percent for U.S. banks) and return on equity was 19.3 percent (compared to 6.8 percent for U.S. banks).

An interesting question is how this might change if China goes through with its stated policy goal of interest rate liberalization. Bank profitability will hinge on how much of the increase in deposit rates can be passed through to borrowers in the form of higher lending rates. The historical record on this subject is mixed; so much depends on the makeup of a country’s financial sector and the relative power of borrowers.

Xiao Gang, the chairman of the Bank of China, estimated in 2010 that the non-liberalized interest rate regime in China gave banks a net interest spread twice as large as that for foreign currency loans in the international market. Given that interest income now accounted for 80 percent of bank income last year, a narrowing of the interest rate spread has serious implications for bank profitability.

After years of financial trouble, Chinese banks now enjoy large profits. The real problem is not the amount of profits being generated by banks per se, but rather that these profits are coming at the expense of Chinese households who have been given a negative real return on their savings since 2004. Interest rate liberalization will fix this problem, but it also means that China’s banks will have to adapt and begin to operate on a truly commercial basis.

The process of interest rate liberalization must be done carefully and gradually in order to avoid a financial shock that disrupts the real economy. Interest rate liberalization, however, cannot be ignored if Chinese policymakers are serious about rebalancing the economy.

Posted in Analysis | Comments 7 | Leave a comment
Tags: Banks, Credit, PBoC, Rebalancing